New England Biz Law Update
In the midst of all the Sarbanes-Oxley regulatory developments, it was easy to miss the Securities and Exchange Commission’s three-page release on June 24.
After all, with the SROs remaking the rules of governance, with the SEC remaking the disclosure landscape, and with the PCAOB remaking the accounting world, how important could it be that the SEC announced its intention to publicly release comment letters and responses, without charge, on its website?
There wasn’t even a proposed rule involved. The SEC simply solicited comments from the public for “suggestions on how to make the transition and process work efficiently.”
Less than a dozen comments concerning this new procedure have been received by the SEC at this writing, so it’s not like the financial world took serious note.
It’s strange that there should be so little reaction to a proposal that will affect virtually all in-house counsel of public companies, and may remake the way in which communications with the SEC are conducted.
SEC Position
The Commission first stated that, historically, its staff has selected certain filings for review, whether a registration statement under the Securities Act of 1933 or a periodic filing under the Securities Exchange Act of 1934. Upon review, the staff issues a letter of comment.
These comment letters are wide ranging, addressing both formalistic and substantive matters. One comment might suggest simply rewriting a caption. The next comment might challenge the company’s entire income recognition approach in the preparation of financial statements. The review typically involves several rounds of staff comments and company responses, after which the staff advises that its review is complete.
The frequency and importance of the comment process will only increase over time. Section 408 of the Sarbanes-Oxley Act requires the Commission to review periodic reports filed by issuers, not less frequently than every three years. Every in-house attorney at a publicly held company either has heard from or will hear from the Commission, and furthermore will hear from them over and over again.
Currently, the SEC releases comment letters and responses only after a formal request under the Freedom of Information Act (FOIA). Noting a recent increase in FOIA requests, the Commission stated that “it is appropriate to expand the transparency of the comment process so that this information is available to a broader audience, free of charge.”
Comment letters and responses would become accessible on the Commission’s website (www.sec.gov), for all reviewed filings made after Aug. 1, not less than 45 days after the staff has completed its review.
SEC Rule 83 permits companies to request confidential treatment for portions of a response. The Commission intends to release only the “redacted” version of response letters where there is a Rule 83 request for confidential treatment, but gratuitously reminds us that it rejects requests for confidential treatment that are “overly broad,” and that there must be an “appropriate basis” to request confidentiality.
There are only narrow grounds properly to assert confidentiality. Most typically, a claimant must identify adverse business consequences that would be occasioned by disclosure and the measures taken by the business to protect the confidentiality of the information. It could also point to the ease or difficulty of any competitor obtaining or compiling that information.
Finally, the SEC intends to include the so-called “Tandy” language in their comment letters. This language prohibits a company from using the SEC’s comment process “as a defense in any securities related litigation against them.”
Thus, presumably, a private suit (or SEC investigative procedure) could be brought against a company for a misstatement or omission in a filing, the plaintiff could refer to the contents of the comment process to demonstrate the inadequacy of disclosure, and the company would not be able to prove that the SEC had acquiesced in that particular form of disclosure.
Public Reaction
Aside from a scattering of laudatory responses, substantive public commentary came primarily from the Financial Reporting Committee and Securities Regulation Committee of the New York City Bar Association.
The Association first listed what can only be characterized as a catalog of fears. Since the public will see these letters, the staff should be particularly careful not to “include assertions based on conjecture.” Also, before the SEC asks for any changes in a disclosure it should fully gather ancillary facts and have extensive telephone conferences with the company.
The SEC should not accidentally disclose matters covered by a Rule 83 confidentiality request, and the Commission should be consistent in its comments. Finally, the SEC should indicate when a particular comment has been withdrawn.
Anticipating an increase in Rule 83 requests for confidentiality, the Association suggests that the SEC should be clear about not releasing supplementary factual information provided by companies in response to inquiries (such returned supplementary material is not subject to FOIA requests); disclosure of proprietary product information should be prevented; and the staff should “be circumspect in drawing initial comments” related to particularly sensitive areas such as revenue recognition, cheap stock, accounting policies, business segments and projections in mergers.
In response to alleged SEC failure carefully to screen materials released in the FOIA process, the Association requests that the Commission provide to a company, two weeks in advance of release, a copy of everything to be publicly released so that that information can be scoured for over-broad inclusions.
In order to prevent distortions in the trading after-market for public offerings and in order to avoid creating a second tier of public information not included in company filings, the Association requests that the SEC wait a full year before releasing comments and responses relating to public offerings, and until the later of one year or the filing of the next Form 10K with respect to comments and responses for filings under the 1934 Act (allowing companies several filings to iron out disclosure issues with the staff).
Comments and responses relating to acquisition filings similarly should be held until one year after the closing or the termination of the transaction, according to the Association. (In a separate comment letter, Sullivan and Cromwell LLP, while asking for a 45-day delay after the conclusion of a business acquisition, noted that the SEC often gives final approval to disclosure relating to an acquisition (for example, a merger proxy), and that such approval could precede closing by many months while companies hold meetings, finish diligence, meet conditions precedent to closing, and obtain regulatory approvals).
The Association also objected to the blanket inclusion of Tandy provisions. Noting that Tandy letters originally were developed so that the SEC clearance of a particular filing would not prejudice the SEC’s right to pursue already pending regulatory action, the Association noted that such inclusion would so prejudice the rights of a company, in defending itself against an SEC action or a third-party suit, that inclusion of the Tandy language should not be undertaken without formal rulemaking procedures and opportunity for full public comment.
The Association also argues for a safe harbor preventing private litigants from using information culled from the comment and response letters and not contained in the filings actually made with the Commission. Expressing the belief that the SEC’s action will lead to “increased litigation, misguided reliance on documents other than prospectus and periodic filings,” more formal requests under Rule 83 and greater stock volatility, the Association concludes with nothing short of an implicit indictment of the SEC’s release.
Some Thoughts On Policy
Why is the SEC doing this? Perhaps the SEC sees itself, in retrospect, as an unwitting instrument of the kind of selective disclosure that the Commission (and Regulation FD) go to great lengths to eliminate.
The idea that in the past a permitted FOIA inquiry might have placed material information, contained in comments and responses, only in the hands of one investor or investment banker with the perspicacity to pursue that information, affording greater insight for trading advantage, may be implicit in the SEC position. Of course, if this were the case, the SEC is a late convert to broad dissemination. FOIA disclosures have made such selective dissemination of information possible for many, many years.
And why is the New York Bar now so upset? Is it not correct that every criticism levied against the SEC policy could have been levied prior to the policy, because each evil recounted also arises when there is selective disclosure under FOIA?
Would the Association attempt to impose its various limits and caveats with respect to FOIA inquiries also? Would such limits even be permissible under FOIA? These are issues that the Association does not tackle.
The SEC and the Association do seem to share one underlying conviction: Broader dissemination of the comment letter process is likely to have far greater impact on the securities markets than the same disclosure to a much smaller group.
Speculating On The Future
Communication with the SEC will never be the same. Broad public dissemination of comments and responses will have a variety of effects, only some of which are noted by the public commentators (possible confusion in the marketplace, proliferation of litigation, unfairness to litigating companies).
The telephone lines to Washington, D.C. are going to get a lot of use. Company counsel is going to pick up the phone and attempt to discuss something sensitive or volatile with the staff, rather than writing a response the staff ultimately may find to be unsatisfactory. The only thing worse than having the SEC publicly comment about something once is to have the SEC comment about it twice.
A regrettable tendency to posture on behalf of one’s position in a more argumentative way may creep into the responses to staff comments.
Conversely, posturing aside, will a company ultimately be less willing to push hard for its position, in the face of Commission resistance and subsequent public dissemination? Even under present practice, how often do practitioners say, “I really don’t think that the SEC is correct here, but if that is the way they want it, then that’s the way they are going to get it.”
There will be a tendency to go slower. If the SEC formally or informally adopts some of the suggestions of the Association, staff will of necessity be more circumspect, involved in more informal dialogue, and consequently less quick to get to the point. If companies are on the telephone, or are carefully composing a comment response that is as much designed to sound good in litigation as it is designed to answer the SEC inquiry, then we may soon see an attenuation of the process.
Will the SEC adopt some of the Association suggestions concerning its own procedures? Much implicit criticism of the staff can be read into the suggestions. You don’t need those kinds of “solutions” unless you have those kinds of “problems.”
Only one thing is certain. Everyone in-house in a public company is going to have to deal with the ramifications of the SEC release, and (if the SEC sticks to its guns) the minimum 45-day release date for reviewed filings made after Aug. 1 will be fast upon us.
Stephen M. Honig is a member of Duane Morris’ corporate department, and is a resident in its Boston office. His practice includes counseling public companies in matters of SEC compliance and corporate governance.
